FINANCE Corporate financial policy and R and D Management

toric returns and risk. An investor should not allocate resources to only
one security, as was the case with many Enron stockholders. Clearly the
standard deviation of return may be minimized by investing in several as-
sets, particularly if these assets are somewhat uncorrelated. An investor
does not benefit from investing in two stocks, as opposed to only one secu-
rity, if both stocks move in parallel. That is, if stock A rises 10 percent and
stock B rises 10 percent, then it is not evident that the investor has any ben-
efits to a second stock investment. If Johnson & Johnson has an expected
return of 8.52 percent and DuPont has an expected return of 3.96 percent,
indicating the stocks are not perfectly correlated with each other, an in-
vestor can purchase an equal dollar amount of each stock and reduce risk.
The correlation coefficient, as we remember, is the covariance of two series,
divided by the product of the respective standard deviations. The correla-
tion coefficient allows an investor to understand the statistical nature of a
covariance because the correlation coefficient is bounded between –1 and
+1. The covariance between two series is calculated as the sum of the prod-
uct of the differences between each series and its respective mean. If the co-
variance of Johnson & Johnson and DuPont is positive, then this implies
that when Johnson & Johnson’s return is above its mean or expected
value, then DuPont’s return is above its mean. The correlation coefficient
of the two series is 0.165, which is relatively low and implies that the in-
vestor might want to have only Johnson & Johnson and DuPont in a two-
asset portfolio. The correlation coefficient of Johnson & Johnson and IBM
is only 0.018, which is the lowest set of correlations in the three assets (see
Table 8.2), and thus one would want to build a two-asset portfolio using
these two securities to minimize risk. The most important question is:
What should be the respective weights in the portfolio of these two securi-
ties to minimize risk?

The Use of Financial Information in the Risk and Return of Equity 203

TABLE 8.2 Monthly Correlation Matrix

Stock

Stock DD IBM JNJ

DD 1.0000 0.2988 0.1646

IBM 0.2988 1.0000 0.0184

JNJ 0.1646 0.0184 1.0000

Data source:Center for Research in

Security Prices.